Statement on Monetary Policy – November 2007 International and Foreign Exchange Markets

Credit and money markets

The period since the previous Statement has been one of considerable turbulence in global financial markets. Credit markets in particular have been very unsettled. Sentiment in financial markets has improved recently, but markets remain vulnerable to further adverse news. While the outlook remains unclear, it does seem, at this stage, that there has been a general repricing of risk in credit markets following a period of several years in which risk spreads had been overly compressed. Assuming that spreads remain at these more elevated levels, there is likely to be a moderation in those financial activities which were dependent on access to unusually cheap funding.

As discussed in the previous Statement, the initial trigger for this current episode of volatility was the collapse of investor confidence in securities backed by US sub-prime mortgage debt. Data had been indicating for some time that US housing market conditions were deteriorating and delinquencies on sub-prime mortgages, in particular, were rising rapidly. A catalyst was the announcement on 9 August by the French bank, BNP Paribas, that it was suspending withdrawals from two of its funds with large exposures to US sub-prime debt. This led to a general reassessment of the risks of participating in structured credit markets.

This increased risk aversion manifested itself in an unwillingness to rollover asset-backed commercial paper (ABCP) (Graph 17). There are two main types of issuer in this market: the largest group are the ABCP ‘conduits’ which are sponsored by banks providing them with contingent liquidity lines that can cover up to 100 per cent of their liabilities; and the second are structured investment vehicles (SIVs) which are not funded exclusively by ABCP and therefore require less liquidity back-up. As the ABCP market dried up, financial vehicles that had funded long-term investments with short-term ABCP turned to their sponsoring banks for liquidity support. But with banks themselves becoming more cautious and less willing to lend to each other, this additional demand for credit was not easily met. Moreover, other markets such as the primary issuance market for collateralised loan obligations virtually closed as investors shunned new issues, forcing banks to expand their own balance sheets and retain the loans they had originated but had been intending to package and sell to investors.

These pressures on liquidity in the interbank funding markets saw interest rates in short-term money markets spike higher (Graph 18). Spreads between the London Interbank Offered Rate (LIBOR) and the expected fed funds rate rose by over 80 basis points. Central banks, including the RBA (see Box D), responded to these developments by injecting substantial cash into the banking system and, in some cases, extending the range of collateral against which they would lend in order to ease the strains on liquidity.^[1] The US Federal Reserve also cut its discount rate (the penalty window at which banks can source additional funds during times of stress) by 50 basis points, and extended the terms of the loans from overnight to 30 days (Graph 19). These central bank operations were not intended to change the overall stance of monetary policy; rather they were aimed at breaking up the log-jams in money markets and encouraging funds to flow more freely. These operations were successful in offsetting the squeeze on overnight cash rates, but the cost of term funding remains elevated relative to overnight indexed swap rates (OIS). As the strains in the short-term money market have eased over the period, central banks have withdrawn some of the additional liquidity that they provided.

The tight liquidity conditions in credit markets have affected the profitability of banks, especially those highly reliant on capital-market funding. Earnings reported by major international banks for the third quarter were typically significantly down on a year ago and several institutions booked an outright loss. Write-downs in asset values were mainly related to securities associated with US sub-prime mortgages and lending to SIVs.

In late September, a large mortgage bank in the UK, Northern Rock, became concerned about its ability to access funding in wholesale markets and sought emergency liquidity from the Bank of England (BoE). In recent years, Northern Rock had experienced rapid growth in market share owing in part to access to cheap funding in global wholesale markets. In the event, the emergency BoE loan and assurances from the Financial Services Authority attesting to the bank's solvency were not sufficient to prevent a depositor ‘run’ on Northern Rock. The run was only halted after the government extended a guarantee on bank deposits.

Money market conditions improved noticeably when the Federal Reserve cut the federal funds target rate by 50 basis points at its September meeting. The improvement in short-term funding conditions was more apparent in the US than European markets.

While liquidity conditions have improved, concerns still remain about SIVs. Many SIVs have invested in fixed income securities including a large portion of structured credit products, which are difficult to price and whose secondary market liquidity is generally very low. In October, a consortium of banks, led by Bank of America and Citibank, announced an in-principle agreement to establish a US$80–100 billion fund to enhance liquidity for the assets of SIVs – which are believed to total around US$320 billion. While terms are yet to be finalised, the fund is expected to hold ABCP and medium-term notes issued by SIVs, thereby preventing a fire sale of their fixed income assets.

Official policy rates

At the time of the previous Statement, most major central banks were expected to tighten policy further in the period ahead with the exception of the US where there were already some concerns about economic prospects. In the wake of recent credit market disturbances, expectations of rate increases have been reassessed by the market. In some counties, expectations have been pared back, reflecting the tightening in credit conditions and the increase in lending costs that have resulted. In other countries, interest rates are still expected to rise, reflecting the strength of the economy and/or a smaller impact of the credit market disturbances.

As noted, the Federal Open Markets Committee (FOMC) cut the federal funds rate by 50 basis points in September, to 4¾ per cent. In its accompanying statement, the FOMC cited the strains in credit and money markets as posing downside risks to the housing sector and the economy more broadly. Prior to this, the fed funds rate had been left unchanged for over a year. Further negative news concerning financial markets and fresh concerns over the housing sector prompted the Fed to cut rates by an additional 25 basis points to 4½ per cent at its October meeting. However, the decision was not unanimous and the accompanying statement indicated that the Fed regarded the downsides to growth as being balanced by upside risks to inflation. Current market expectations are for rates to decline a further 50 basis points to 4 per cent over the coming six months (Graph 20).

Notwithstanding the Bank of Japan's (BoJ) commitment to a gradual normalisation of rates, softer economic data has led the market to become less certain that there will be scope to increase the policy rate by another 25 basis points in the next six months.

The European Central Bank (ECB) has left its policy rate unchanged. While noting the turbulence in financial markets, ECB officials have continued to highlight their concern over the inflation outlook. The market currently expects the ECB to maintain the policy rate at 4 per cent for the foreseeable future, having previously expected a further tightening. The market has also removed its expectations of further policy tightening by the Bank of England. Indeed, with the tightening of credit conditions in the UK, coupled with a downward revision to the BoE's inflation forecast, the market currently expects a 25 basis point cut in the policy rate in the next six months.

Elsewhere in Europe, over the past three months, policy rates were lifted by 50 basis points in Norway and Sweden and 25 basis points in Switzerland to 5 per cent, 4 per cent and 2¾ per cent, respectively (Graph 21). Both the Reserve Bank of New Zealand and the Bank of Canada kept their policy rates unchanged over the past three months. While rates are expected to be left unchanged in New Zealand, a 25 basis point cut is expected in Canada within the next six months.

Reflecting the strength of the Chinese economy and the continuing rapid growth in money and credit, monetary conditions in China continued to be tightened (Graph 22). Since the previous Statement, the People's Bank of China (PBoC) has raised the required reserves ratio for banks twice, by a total of 100 basis points, to 13 per cent. It also lifted the official one-year lending and deposit rates by over 25 basis points to 7.29 per cent and 3.87 per cent, respectively. Action was taken to cool speculation in China's property market, with both mortgage rates and deposit requirements increased for those buying a second property, or a property for commercial use.

Similarly, with ongoing inflation pressures and strong economic conditions in a number of other emerging market economies, policy rates were raised in Taiwan, Mexico, Israel, Poland and the Czech Republic, with particularly large increases in South Africa and Chile. In contrast, central banks in Hungary, Turkey, Brazil and the Philippines all eased policy in the last three months, citing abating inflationary pressure and concerns over their growth outlook.

Bond yields

Major market government bond yields have declined since the previous Statement and have exhibited some volatility. Movements in the US bond market have primarily been driven by the credit market developments discussed above and US policy moves (Graph 23). The two policy actions by the Fed both saw yields move higher, but credit market concerns have seen yields decline to lows of around 4.30 per cent. German and Japanese government bond markets largely took their lead from the US, although the decline in yields was less pronounced than for the US.

The credit concerns in the financial sector resulted in spreads on higher-rated US corporate debt increasing in August and September, before narrowing slightly in October. However, the increase in spreads since the previous Statement has largely reflected the fall in US government bond yields, so that the yields for higher-rated corporates have actually fallen (Graph 24). This has been reflected in the rebound of corporate bond issuance in the US to more normal levels, following a period in late July and August where issuance was particularly low. Spreads for US speculative grade corporate debt have widened noticeably, in line with the expected slowdown in the US economy.

Spreads on emerging market debt have widened slightly since the previous Statement, although they still remain at relatively low levels (Graph 25). Again the widening in spreads largely reflected movements in US government yields rather than a tightening in credit conditions in these economies.

Equities

Global equity markets have been extremely volatile over the past three months reflecting the fluctuation in sentiment about credit markets (Graph 26, Table 3). Markets fell sharply in August as risk retrenchment took hold, but rose sharply following the Federal Reserve's September rate cut. Financial stocks have been most affected by the credit market concerns, and remain significantly below their level prior to the onset of the current difficulties. The large write-downs by international banks of their credit market exposures in recent weeks has had a mixed impact on their share prices. In some cases, the share price rose sharply following the earnings announcements but in other cases, it fell noticeably.

While share markets in the US and Europe are generally little changed in net terms since the previous Statement, and the Japanese market has fallen, emerging market equities have posted sizeable gains, notwithstanding some sharp falls in August and again in late October (Graph 27). Gains have been particularly strong in Asian markets, led by the Hong Kong and Chinese markets, as foreign investors sought further exposure to the rapidly expanding Chinese economy. In India, regulations that were aimed at limiting foreign inflows precipitated a sharp fall in prices which dragged down other share markets in the region and spilled over to developed markets. However, after regulators rescinded the proposed measures, markets rebounded firmly. Share prices in India are now up by 50 per cent over the past year, and have recorded average annual growth of 45 per cent over the past five years.

Exchange rates

The major development in foreign exchange markets has been the depreciation of the US dollar against all major currencies (Table 4). On a trade-weighted basis, the nominal exchange rate is at its lowest level in over thirty years, and the real exchange rate is only slightly above its 1995 trough (Graph 28). While the US dollar initially rose against most other currencies amid the financial market uncertainty of August, the combination of weaker-than-expected US economic data, the easings by the Fed and expectations of a further decline in interest-rate differentials with other economies contributed to a sizeable depreciation in the dollar over the remainder of the period.

The euro has appreciated strongly against the US dollar since the last Statement, and is trading at its highest level since the introduction of the currency in 1999. However, the movement of the dollar against the yen has fluctuated markedly with the changes in risk appetite in financial markets (Graph 29). The increased risk aversion in August saw a large unwinding of carry trades as investors chose to book profits from their investments in high-yielding currencies such as the New Zealand and Australian dollars (see below), in part to cover losses on other investments. Renewed risk appetite in the following months, along with weaker Japanese economic data and expectations the BoJ will delay raising interest rates, has seen the re-establishment of carry trades again weigh on the yen.

The Canadian dollar has risen particularly sharply against the US dollar since the last Statement, reaching parity for the first time since 1976 (Graph 30). The Canadian dollar has been supported by rising oil prices along with the narrowing interest rate differential with the US. In contrast, the British pound has appreciated more modestly against the US dollar over the same period, primarily reflecting the concerns surrounding the mortgage lender, Northern Rock.

Emerging market currencies mostly appreciated against the US dollar over recent months, notwithstanding a depreciation during the risk aversion of August. The Brazilian real experienced one of the strongest appreciations among emerging market currencies supported by improved economic fundamentals. Emerging Asian currencies have appreciated modestly, among the largest gains being for the Singapore dollar and Malaysian ringgit.

The Chinese renminbi has appreciated moderately against the US dollar since the last Statement (Table 5). However, on a nominal trade-weighted basis the renminbi has been little changed as most other currencies have appreciated more strongly against the US dollar over the period (Graph 31). Pricing in the non-deliverable forwards market indicates expectations of a 7 per cent appreciation in the renminbi against the US dollar over the next year. The continued intervention by the Chinese authorities to limit the pace of nominal appreciation of the renminbi has seen foreign reserves reach US$1.4 trillion in September.

Australian dollar

The Australian dollar has traded in a very large range of over 17 US cents since the previous Statement (Graph 32), but in net terms has appreciated strongly to reach multi-year highs of 73 on a trade-weighted basis and 94 US cents (Graph 33, Table 6). Movements in the Australian dollar over the past few months have been largely driven by swings in investor risk appetite, with sizeable intraday movements in the currency in both directions. Volatility in the currency spiked higher in August to reach its highest level since early 1985 (Graph 34). There was a particularly sharp depreciation in mid August as the rise in global risk aversion arising from the credit market crunch triggered an unwinding of carry trades. In response to the thin and disorderly conditions in foreign exchange markets at the time, the Reserve Bank dealt in the market to add liquidity by selling foreign exchange and purchasing Australian dollars. This is the first time that the Bank has bought Australian dollars in the market since 2001.

Since then, the Australian dollar has largely tracked upwards as market conditions have begun to normalise, and signs of renewed appetite for risk have appeared. Over this period however, the currency has been particularly sensitive to global financial market developments, with any reports of problems in financial intermediaries and/or evidence of a slowdown in the global economy tending to lead to a depreciation. Reflecting the sensitivity to risk, the local currency has tended to move in line with equity markets, with the correlation between the two assets recently reaching very high levels (Graph 35).

While part of the appreciation reflects the broad-based depreciation of the US dollar, the Australian dollar has been boosted by a number of other factors. The terms of trade remain at an historically high level, reflecting the strength in commodity prices (see the chapter on ‘International Economic Developments’). Also, the strength of the local economy and the resulting level of yields compared to other major economies have provided support. Positive interest rate differentials have attracted significant capital inflows into Australia, with the bulk of these inflows in debt markets and money market instruments (Graph 36). Net equity flows have tended to be smaller in size, with an inflow of equity capital from abroad offsetting the outflow of equity in the June quarter (the most recent data available).

Net long speculative positions in Australian dollar futures on the Chicago Mercantile Exchange were significantly unwound in August, but have since increased again to around half the record level reached at the end of 2006 (Graph 37). Similarly, risk reversals, which provide a measure of the market's expectations of the future direction of the exchange rate, fell to record levels in August as participants became more concerned about the prospect of a sizeable depreciation of the Australian dollar.^[2] While risk reversals have partially retraced their path, they remain well below their long-term average.

With the Australian dollar reaching a 23-year high against the US dollar, the Reserve Bank has continued its purchases of foreign exchange in recent months. Net purchases of foreign exchange and earnings over the year to date total $5 billion, bringing net reserves to around $33¼ billion. The Bank's holdings of foreign exchange under swap agreements are around $3 billion, down from $47½ billion at the end of the June quarter. This reflects a shift in domestic operations towards bank bill repurchase agreements that began during the recent turmoil in credit markets, and some reduction in the Bank's deposit liabilities to the government sector.

Footnotes

See Battellino R (2007), ‘Central Bank Open Market Operations’, RBA Bulletin, September, pp 19–26. [1]

A risk reversal is an option portfolio consisting of two out-of-the-money options: a long call option and a short put option. The risk reversal's price is the price of the call option minus the price of the put option. [2]